And it did this just after releasing a huge MBA-style document on
how to make money on content called The AOL Way.

Talk about enormous changes!

But that was yesterday. Now the fun's over. And it's
time to talk through the reality of the situation.

The reality of the situation is this:

More than half of AOL's revenue and all of its
profit (our estimate) come from two dying
businesses: dial-up Internet access and search.

These two businesses are shrinking at 20+% per
year.

Now, no one cares about these businesses or gives them a moment's
thought. But, again, they're likely producing all of AOL's
profit. And that means that the core business, the one that
AOL is asking investors to bet on, is still in lousy shape.

What is this core business?

Content.

Yes, AOL also has an ad-network called
Advertising.com that still generates $350
million of revenue a year. But that's a low-margin business, and
it's shrinking at a startling 40%+ per year. So let's
ignore it. (AOL should just sell this business and use the
proceeds to buy more premium content businesses).

As of Q4, AOL's content business looked something like this:

$600 million of revenue (annualized), shrinking 8% per
year.

Our analysis (which we'll detail in a forthcoming post) suggests
that AOL's content business is at best break-even and, more
likely, is losing money. If this business is to become
AOL's primary profit growth engine in future years, therefore, it
will have to be radically restructured.

Specifically, it will have to have enough cost cut out of it to
produce a pre-tax profit margin of a respectable 20%.

How much cost is that?

Assuming the business is currently break-even, and assuming
revenue doesn't shrink further (it will), AOL needs
to cut at least $120 million of cost out of this
business. It will then need to begin to grow
the revenue of the business by, say, 20% per year.

Now, cutting 20% of the costs out of a $600 million business,
stopping the revenue declines, and then accelerating revenue
growth to 20% a year is no mean feat.

This is especially true because AOL's content business likely has
at least 2,000 employees toiling away on dozens of different
projects and brands.

Yes, these employees have recently been reorganized into "towns,"
but they're going to have to be reorganized far more than that.
And at least 1 in 5 of them will likely have to leave the
company.

2,000 employees, by the way, is about 10X as many employees as
work at the Huffington Post.

So, Arianna has her work cut out for her!

Specifically, Arianna is going to need to hire a team of
executives with serious turnaround experience--executives who can
get the cost structure of AOL's content business in shape, figure
out a cohesive strategy in which all the individual brands serve
the company's content mission, and then get the display-ad
revenue growth engine cranking again.

Assuming Arianna can pull this off--and, if she can, she will be
able to take her place in the pantheon of legendary
managers--what will this business look like?

Will AOL's content business grow like that? We doubt it. But
let's give Arianna the benefit of the doubt.

If AOL's content business grows like that, what will happen to
the overall company's operating profit?

Unfortunately, it will continue to decline, unless AOL cuts
vastly more costs out of the business.

Why?

Because, right now, AOL's operating profit is declining by 20%+
per year, or $200 million. The content business growth that
we penciled in above would offset that decline to some extent,
but it wouldn't turn it into growth.

(In the above scenario, AOL's content business would add $100
million of annualized profit from the initial cost cut, then $44
million of growth the following year and $35 million in the year
after that. Even if you took all that growth in a
single year and repeated it every year, it
wouldn't offset the $200 million profit shrinkage per year AOL is
currently experiencing).

So, for AOL to ever grow operating profit again, not only does
the content business have to perform as outlined above, the two
dying businesses--search and dial-up--have to stabilize
quickly. And there's almost no chance of that happening.

BUT HERE'S THE GOOD NEWS...

The good news is that AOL's content business, if it can get its
act together, can be a very valuable business all on its own.

Demand Media, a public comparable company
that is partially in the content business, is currently trading
at about 6X-7X trailing 12-month revenue of about $250 million.

AP

Demand Media is growing, which AOL's content business currently
isn't. But for the sake of argument, let's assume AOL can get its
content business growing again, in the way we outlined above.

In that scenario, AOL's content business alone could be worth
6X-7X revenue, or $3.6 billion-$4 billion on the $600 million of
revenue. To be conservative, though, let's say AOL's content
business will never achieve even a Demand-Media-like valuation
(*shudder*), and assume that AOL's content business will only
trade at 5X revenue. That's still $3 billion.

Right now, AOL is trading at a $2 billion valuation.

That means the market is assuming that AOL will NEVER get its
content business headed in the right direction. (It might). It
also means the market is assuming that AOL's two dying
businesses, search and dial-up, won't continue to pump out
hundreds of millions of dollars of cash over the next several
years while they die. (They will.)

And that means there actually is an upside scenario here for the
stock and company even if the search and dial-up businesses
continue to die. (They will).

WHAT AOL SHOULD DO

By the way, the best strategy for AOL going forward is revealed
by the analysis above.

AOL should quickly sell Advertising.com, MapQuest, and any other
properties that don't serve the content business, isolate the
dial-up and search businesses in a separate part of the P&L,
and focus all of its efforts on the content business. It
should break out the performance of this business--top and bottom
lines--and focus on growing both revenue and profits. And
it should make sure investors and employees are focused on the
progress of the content business.

Then, because scale is a huge advantage here, AOL should keep
re-investing the cash produced by the dying business in new
content brands it can bolt onto its ad sales and technology
infrastructure.

By doing this--and only this--AOL has a path to building the
content company for the 21st Century, which, if memory serves, is
what Tim Armstrong wanted to build.